- Risk parity, an investing strategy that allocates to different asset classes based on their levels of volatility, was once hailed as “nirvana” by Morgan Stanley’s equities chief.
- However, it took a severe beating as the stock market plunged last week and failed as a diversifier of risk.
- Morgan Stanley explained how this development will change investing behavior, and offered alternative hedges for future stock-market turmoil.
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The stock market’s historic plunge last week was a stress test for investors who had found success during less-severe episodes.
During pullbacks that preceded the coronavirus-driven bear market, a strategy known as risk parity successfully cushioned the blow to portfolios. In practice, it employs leverage to spread investment risk across various asset classes based on their levels of volatility.
It was endorsed and popularized by Ray Dalio, the founder of Bridgewater Associates, which is the world’s largest hedge fund. His firm considers it a balanced and superior approach to achieving investment success compared to what traditional stock-focused portfolios offer.
The strategy was particularly effective in the 15 months leading up to Wednesday March 11, the final day of the longest bull market in history. According to data compiled by Morgan Stanley, its average performance during those months exceeded the 20-year average.
Investors who diversified their stock portfolios with long-dated Treasuries enjoyed a hedge against declines, capital gains in bonds, and diversification.
These three benefits were so attractive that Morgan Stanley’s US equities chief Mike Wilson described them as “risk parity nirvana.”
But it did not deliver last week when it was needed the most.
As stocks fell early on Wednesday, bonds initially rose, but eventually caved and sent yields higher amid the widespread virus panic. The anomaly of these simultaneous moves — falling stock prices and rising yields — is illustrated in the chart below.
“While one day does not make a trend, and many factors were at play, we expect this issue to get more focus,” said Andrew Sheets, the chief cross-asset strategist at Morgan Stanley, in a recent note.
At issue is that the 30-year Treasury yield is already near a record low and the Federal Reserve is unwilling to implement negative interest rates. Because bond prices move in the opposite direction to their yields, the capital gains from Treasuries become more constrained as yields approach the theoretical floor of zero.
For investors, this means the runway for bonds to outperform when the stock market falls is shrinking.
“Less diversification from bonds is a negative for broader markets, especially when hedging through volatility has rarely been more expensive,” Sheets said.
This setback for risk parity should prompt a rethinking of how investors take risks in the stock market, Sheets added.
“Less diversification implies less overall equity exposure, he said.
If bonds are providing less diversification in a balanced portfolio, it follows that investors need to dial down their exposure to risk. Alternatively, they can hold the same exposure but with a higher tolerance for volatility. And considering the uncertainties surrounding COVID-19, investors should be strapped in for more wild swings in markets.
Sheets concludes that investors will need to find non-bond diversifiers going forward.
He screened for trades that have low, stable correlations to global stocks so that they aren’t moving in the same direction. He also looked for trades that are reasonably valued and have a lower cost-of-carry.